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AnnouncementProblemSet2:DueonApril9ReducingRiskConsumersaregenerallyriskaverseandthereforewanttoreduceriskThreewaysconsumersattempttoreduceriskare:1.Diversification2.Insurance3.ObtainingmoreinformationReducingRiskDiversification◦ReducingriskbyallocatingresourcestoavarietyofactivitieswhoseoutcomesarenotcloselyrelatedExample:◦Supposeafirmhasachoiceofsellingairconditioners,heaters,orboth◦Theprobabilityofitbeinghotorcoldis0.5◦Howdoesafirmdecidewhattosell?IncomefromSalesofAppliancesHotWeatherColdWeatherAirconditionersales$30,000$12,000Heatersales12,00030,000Diversification–ExampleIfthefirmsellsonlyheatersorairconditionerstheirincomewillbeeither$12,000or$30,000Theirexpectedincomewouldbe:◦1/2($12,000)+1/2($30,000)=$21,000Diversification–ExampleIfthefirmdividestheirtimeevenlybetweenappliances,theirairconditioningandheatingsaleswouldbehalftheiroriginalvaluesIfitwerehot,theirexpectedincomewouldbe$15,000fromairconditionersand$6,000fromheaters,or$21,000Ifitwerecold,theirexpectedincomewouldbe$6,000fromairconditionersand$15,000fromheaters,or$21,000Diversification–ExampleWithdiversification,expectedincomeis$21,000withnoriskBetteroffdiversifyingtominimizeriskFirmscanreduceriskbydiversifyingamongavarietyofactivitiesthatarenotcloselyrelatedReducingRisk–TheStockMarketIfinvestallmoneyinonestock,thentakeonalotofrisk◦Ifthatstocklosesvalue,youloseallyourinvestmentvalueCanspreadriskoutbyinvestinginmanydifferentstocksorinvestments◦Ex:MutualfundsReducingRisk–InsuranceRiskaversearewillingtopaytoavoidriskIfthecostofinsuranceequalstheexpectedloss,riskaversepeoplewillbuyenoughinsurancetorecoverfullyfromapotentialfinanciallossTheDecisiontoInsureReducingRisk–InsuranceFortheriskaverseconsumer,guaranteeofsameincomeregardlessofoutcomehashigherutilitythanfacingtheprobabilityofriskExpectedutilitywithinsuranceishigherthanwithoutTheLawofLargeNumbersInsurancecompaniesknowthatalthoughsingleeventsarerandomandlargelyunpredictable,theaverageoutcomeofmany...